Skip to main content

Fiscal Policy

Why Should I Care?

Politicians are taxing you, and spending your money. You might be interested to know why. Often, government is using its budget to try to “fine-tune” the economy to create jobs or stem inflation.

This Lecture Has 5 Parts

  • Automatic Stabilizers
  • Discretionary Fiscal Policy
  • Fine-tuning the Business Cycle
  • Problems with Fiscal Policy
  • What is Austerity?

What is Fiscal Policy?

Governments use the level of taxes, and the level of government expenditure, to manage the economy. Note that fiscal means tax, and government spending comes from taxes. Usually, fiscal policy is discussed in the context of a recession. This is the reason Keynes wrote his theory arguing in favour of government intervention, in the first place. But fiscal policy can also be used, in reverse, during a period of over-heating.

  • Automatic Stabilizers

Some government programs automatically increase spending when the economy is in a slump. These programs distribute money to people without a vote in the House of Commons. We usually refer to these programs as the basis of our social safety net, which broadly speaking also includes universal health care and education. These are like shock absorbers on a car. You don’t have to activate them for them to absorb shocks. The most important policy in this regard are income transfers whose generosity will automatically increase during a recession. In Canada, there are a few programs that will do this such as welfare payments, employment insurance benefits, and farm subsidies. Some countries go so far as to pay individuals to back to school, which would be more prevalent during a recession.

The tax system can also act as an automatic stabilizer. If you see your income decline, but are not laid off (maybe your employer cut your hours), you may be subject to an income tax refund. This is because your marginal income tax rate may have decreased. Of course this progressive taxation regime will greatly reduce the governments income tax revenues, but for individuals, it will help to alleviate the financial burden of earning lower income.

Automatic stabilizers are permanent programs, but they remain the prerogative of elected officials. They should be designed like plumbing, with the maximum flow capacity installed from the beginning, keeping in mind that the average flow in the long-run might be much smaller. This is why your house has really big water pipes, so that the infrastructure does not break down when everyone wants to use the system at the same time. This being said, you do want the flow of stabilization income to reduce by itself as the economy gets better, since you don't want to jeopardize the state's fiscal situation.

  • Discretionary Fiscal Policy

In some countries, there are not many automatic stabilizers in place. In other countries, politicians may feel automatic stabilizers will not generate enough money to compensate the major negative impact of a recession, or over-heating. It is up to their discretion to vote, in Parliament, on a special package changes to spending or taxes. This is called discretionary fiscal policy, and it is a political decision.

There are two tools used in Fiscal Policy: 1) changes to tax levels, and 2) changes to government spending. Changes to tax levels have an effect on Aggregate Demand (AD), through consumption and investment. Changes to government spending (G) affect AD directly, as G is part of AD. A change in G can be important because this component of AD represents about 20 % of GDP.

When fiscal policy is designed to grow the economy, we call it Expansionary. In this case, taxes are decreased, and G is increased. This leads to a budget deficit and new debt. When fiscal policy is designed to shrink the economy, we call it Contractionary or Restrictive. In this case, taxes are increased, and G is decreased. This leads to a budget surplus.

Discretionary Fiscal Policy is like the brake and gas pedals on a car. You have to “manually” activate the program.

If G goes up, Budget Balance becomes  G  >  T :  DEFICIT, and – all else constant – Y goes UP, because Y = C + I + G + X-M.

  • Problems with Fiscal Policy

Expansionary policy has four main problems.

  1. It is expensive; future generations will have to pay off the debt with higher taxes and/or fewer services.
  2. It can be very slow coming; lags are numerous because of the political process.
  3. Savings and Imports reduce the impact.
  4. There are no laws to ban buying robots or improving production processes; the economy’s potential GDP keeps growing. This makes it doubly hard to plan the stimulus because the output gap keeps growing.

Contractionary policy has two main problems.

  1. It is a difficult sell for politicians. How can you win elections when you increase taxes and simultaneously decrease government expenditures and services?
  2. Projects are left unfinished; waste of tax-payer money.

Overall, the Keynes Fiscal Playbook is flawed, according to classically-minded economists, because politicians are in charge of fiscal matters, and they don’t have an incentive to follow the playbook to the letter. They argue the Keynesianism of the 1960's and 1970's has left us with excessive debt, due to recession-time deficits, that have not been paid off with expansion-time surpluses.

Countries of Europe and North America seduced by Keynesian economics in the 1960’s and 1970’s have thus been left with unmanageable debt levels which eventually have to be paid off. When this happens, the solution proposed is called austerity measures, which may result in severe cuts to public services, and economic stagnation.

Summary Table

Expansionary Fiscal Policy

Contractionary Fiscal Policy

What?

t    DOWN        G  UP      

t     UP    G    DOWN  

Why?

To Create Jobs

To Reduce Inflation

Who?

Parliament (H + S)

Parliament

When?

Recession

Over-heating

How?

t down, C up, Y up


G up, Y up

t up, C down, Y down


G down, Y down

Budget Position

Budget Deficit

Budget Surplus

Pros

Region Specific

Leave Assets to Next Generation

Reduce the debt burden

Improve future borrowing capacity

Cons

Expensive

Lags

Political Suicide

  • What is Austerity?

It is important to differentiate austerity policy, from contractionary fiscal policy. Austerity measures are not meant to manage the business cycle. The main goal of austerity is to run a budget surplus which can serve to reduce public debt. The main tool of austerity is to reduce public spending, such as health care services and education, but also other forms of government activity including embassies, military operations, environmental protection, maintenance of transportation infrastructure, housing, and law enforcement. These are commonly called budget cuts.

Another tool of austerity is to modify tax policy to incentivize productive investment, towards the benefit of entrepreneurs and investors. The government reduces taxes on capital expenditure, research and development, and other investments. The idea is to stimulate economic growth while reducing the state's payroll. Meanwhile, taxes on workers, and consumers will remain high to generate as much government income as possible.

If the policy works, economic growth ensues. This allows to compensate, in the longer term, for the short-term pain imposed by the cuts.

If the policy does not work, economic stagnation compounds with the fact that this type of policy would tend to increase the inequality of income and wealth in society. There may be support for this policy among wealthier citizens, but the middle class would bear the brunt of the disadvantages.

Extreme austerity would imply drastic cuts to services, such as hospital shut-downs and the privatization of most services, as well as decreases in tax rates across the board. The goal here is to reduce the size of government in the foreseeable future by limiting its ability to raise tax funds.

Austerity measures are usually put in place when a government's debt has become very large and its interest payments make up an unsustainable share of its annual budget. This was the case in Canada in the 1990's. After decades of budget deficits, the country's debt had accumulated to very high levels. At this point, foreign lenders start to become nervous that the country will default and never pay the debt in full. This situation has plagued many countries such as Greece, Italy, Argentina, and Spain. It was also the case of Newfoundland, prior to its annexation to Canada in 1951.

Austerity is a term that was coined in the 1990's by left-wing politicians and analysts, concerned with the debt reduction measures put in place by what was commonly called the neo-liberal right-wing.

Summary Table - Austerity vs Contractionary Policy
Policy
 Spending on Public Services
 Tax Policy
Contractionary Fiscal
 Reduction
 Overall increase
Austerity
 Drastic Reduction
 Targeted decrease


Wrap-Up

The Government Budget impacts the economy. When the budget is in deficit, the extra spending stimulates the economy. Some government programs act automatically to push money during a recession: farm subsidies, progressive taxes, and employment insurance.

Discretionary Fiscal Policy is used to boost Aggregate Demand. Decreased taxes stimulate consumption and investment, and increased government spending directly contributes to AD.

Cheat Sheet

Balanced budget:
When government expenditures are equal to tax revenues.

Budget deficit:
When government expenditures are superior to tax revenues.

Fiscal Policy:
Changes to tax rates or government expenditures.

Automatic Stabilizers:
Programs which automatically increase spending during a recession.

Discretionary Fiscal Policy:
Spending programs which need a vote in Parliament to be enacted.

Austerity:
Targeted tax reductions accompanied by general reductions of public services, whose aim is to generate a budget surplus and reduce government debt.

References and Further Reading

Hayes, A. (2023). Understanding Austerity, Types of Austerity Measures, and Examples. Inverstopedia.com. https://www.investopedia.com/terms/a/austerity.asp

Stiglitz, J. E. & Walsh, C. E. (2006). Economics, 4th Edition. New York City: W.W. Norton. Ch. 33.



No Comments
Back to top